Analysis: Wall St to learn if Dodd-Frank bark worse than bite

Chairman of the Senate Banking Committee Christopher Dodd (D-CT) speaks to the press alongside Rep. Barney Frank (D-MA) outside the West Wing of the White House in Washington, May 21, 2010.
REUTERS/Jason Reed

WASHINGTON Wall Street will soon get an idea of just how far the regulatory pendulum will swing.

A year after passage of the Dodd-Frank financial reform law, policymakers have yet to detail many of the rules that will determine if high-flying Wall Street giants become heavily regulated and marginally profitable financial utilities, or if they'll simply get their wings clipped.

In the next few months, three reforms linked to profits will come into focus: capital and liquidity standards, the Volcker limits on proprietary trading, and whether banks will have to restructure to make it easier for regulators to break them up.

"The very bank-specific stuff is coming at us... what kind of business are banks going to be allowed to be in, what will the business of banking be going forward," said Wayne Abernathy, a top official at the American Bankers Association.

The Federal Reserve, as early as this month, is set to issue a proposal on what new, tougher capital and liquidity requirements large U.S. banks will have to meet.

Liquidity reforms, in particular, have so far been vague at best. They are important to Wall Street because the most liquid assets can be the some of the least profitable.

The global group of Basel negotiators have yet to tackle the issue and bankers are eager to see whether the Fed will jump ahead with a concrete proposal this summer, or wait for those negotiations to catch up to the Dodd-Frank timeline.

"I haven't seen anything and it's kind of disheartening," said Christopher Mutascio, a bank analyst at Stifel Nicolaus. "We're still focused on capital and we're not looking at the left hand which is liquidity, and I think they should go hand in hand."

Banks are already squawking at tougher capital rules agreed to by global regulators, saying they will force banks to sit on assets instead of seeking a return on them.

The Basel III agreement will require banks to hold top-quality capital equal to 7 percent of their risk-bearing assets, more than triple current standards.

On top of that, global "systemic" banks -- a group expected to include JPMorgan, Bank of America, Citigroup, Goldman Sachs, Morgan Stanley, and Wells Fargo -- may have to hold up to an additional 2.5 percent buffer. Another 1 percent surcharge would be imposed if a bank becomes significantly bigger.

"God knows why we have to hold all that capital, but that's where we are," JPMorgan Chief Executive Jamie Dimon said during last week's earnings call.

The Fed has to decide whether be stricter than the Basel accord -- a worst-case scenario for banks -- under the power given to it by Dodd-Frank to ensure banks are less susceptible to financial shocks.

That stricter scenario looked like a real possibility after Fed Governor Daniel Tarullo floated some provocative capital ideas in early June.

But it has become more remote since the United States got much of what it wanted out of late June's international capital negotiations.

Regardless, the tougher standards will require banks to fund themselves more with equity and less with debt.

Even if the Fed rule largely mirrors what was agreed to in the Basel pact, banks are worried they will have a harder time attracting investors because they will have to keep more equity on their books rather than return it to shareholders.

"From a shareholder's perspective that is going to have the biggest impact on the profitability, the return on equity for these banks," said Gerard Cassidy, an analyst at RBC Capital Markets.

Clarity on these capital requirements could trigger big changes on Wall Street. A July 13 research note from Nomura said that banks may shift resources into lines of business that can provide more of a return on capital, such as asset management, traditional investment banking, and emerging market consumer banking.

VOLCKER RULE, LIVING WILLS

Several other key aspects of the law will be revealed in the coming months, including the Volcker rule.

The Volcker rule, named after former Fed Chairman Paul Volcker, bans banks from trading for their own profit in securities, derivatives and certain other financial instruments.

An initial proposal is expected this summer with a final rule due by October.

Banks such as Goldman Sachs have already shut down their stand-alone proprietary trading desks since the law was enacted, but regulators have yet to define what trading is still permissible.

The key question is what will define trades that are intended to make a market for a client, a revenue-rich business that banks are not eager to see curtailed.

"Banking organizations need to know, particularly in the litigious U.S. environment, where the line is between legal and illegal activity," Hal Scott, a Harvard law professor specializing in international financial systems, told a recent congressional hearing.

Financial regulators are also packing a wild-card weapon that gives them the ability to break up Wall Street banks.

Regulators expect to issue a final rule this summer on how banks should draft "living wills" providing regulators with a roadmap for how to break them up if they begin to falter.

If regulators deem the living wills unacceptable, they could force them to reorganize business lines, form foreign subsidiaries, or even downsize so they are easier to liquidate.

Former Federal Deposit Insurance Corp Chairman Sheila Bair aggressively made the case that regulators should force these changes if they are not made voluntarily.

But Bair left her post earlier this month, leaving open the question of whether Federal Reserve officials and her replacement at the FDIC will aggressively pursue this tactic.

(Reporting by Dave Clarke in Washington and David Henry in New York, Editing by Tim Dobbyn)

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